Damages in litigation: Income tax and CGT considerations1
Introduction
It may be accepted as uncontroversial that "the only two certainties in life are
death and taxes."2 It can also be accepted that, as a general proposition, the
function of damages is to provide fair compensation for a loss sustained by a
plaintiff, and as its corollary, that the assessment of damages should also be fair
to the defendant, and not result in a windfall to the plaintiff.
The official topic for this morning was to be entitled ‘Essential tax
considerations in non-tax cases’. As will be observed, I have re-named it:
‘Damages in litigation: Income tax and CGT considerations’. Essentially, I have
done this for two reasons. First, because, from a review of cases in which
income tax and CGT issues have been arisen, it became clear that this is an area
of the assessment of damages which has been regularly overlooked by
practitioners in preparing and conducting trials, particularly in commercial
matters, and it has the potential to present as a significant and unexpected
impost for plaintiffs after the litigation has concluded. Secondly, because the
subject of Goods and Services Tax is not addressed in this paper.
Distinction between income and capital
It is important to distinguish between income and capital gains because the
amount of tax payable on income and capital profits may differ depending on
whether they are taxed under the income tax regime or the CGT regime. For
example, CGT discounts may apply or CGT may not be applicable to the disposal
if the underlying asset was acquired prior to 20th of September 1985.
For taxation purposes ‘the character of a receipt is assessed by reference to its
character in the hands of the taxpayer, not the character of the expenditure
1
G A Thompson SC., 2 March 2012
In preparing this paper I have been greatly assisted by the following articles: ‘The Courts, tax
and commercial litigation’, Justice Ian Gzell (2007) 81 ALJ 866; ‘Taxation of compensatory
Payments and Judgments’, Hon CW Pincus and S White (2001) 75 ALJ 378.
2
Attributed to Mark Twain, but the quote may have originated from 1789 letter from Benjamin
Franklin to Jean-Baptiste Leroy.
2
which produces the payment to the taxpayer’.3 Relevantly, a compensation
receipt takes on the character of the item it replaces.
If damages are awarded for lost income the damages will be classified as
income and taxed as such under s.6-5 of the Income Tax Assessment Act 1997
(ITAA 1997). Section 6-5(1) ITAA 1997 provides:
“Your assessable income includes income according to ordinary concepts,
which is called ordinary income”.
ITAA does not further define the expression ‘income according to ordinary
concepts’. It is beyond the scope of this paper to review the many authorities
on the meaning of that expression. Suffice it for present purposes to observe
that the indicia of income include periodicity, recurrence, regularity and the
character of the receipt: personal earnings from the performance of services as
an employee or contractor, amounts received as a result of carrying on business
and receipts in the nature of a return on invested capital, such as interest or
rent.
If the damages are awarded as compensation for lost capital, the damages will
be classified as capital and may be subject to capital gains tax under the CGT
provisions in Pts 3-1 and 3-3 of ITAA97. However, not all compensation receipts
of a capital nature are subject to CGT.
It is well-established that an undifferentiated lump sum received (for example,
as a settlement) in satisfaction partly of claims of a revenue nature and partly of
claims of a personal or capital nature is not assessable for income tax, provided
it is not possible to say some identifiable part can be characterized as or is
calculable as being for revenue.4
Where the payment can be dissected into its income and capital components,
the income components (such as interest) will be assessable as income.
Federal Commissioner of Taxation v Rowe (1997) 187 CLR 266 at 279 per Brennan CJ,
Dawson, Toohey and McHugh JJ.
3
4 Commissioner of Taxation v CSR Ltd (2000) 104 FCR 44 at [41] – [49]; McLaurin v FCT (1961)
104 CLR 381 and Allsop v FCT (1965) 113 CLR 341.
3
However, where lump sum damages or a lump sum settlement of an
unliquidated claim which covers both income and capital elements but which
cannot be dissected into those elements, is received, the whole amount is
treated as capital. This treatment of undissected amounts was favourable to
taxpayers before the introduction of CGT. However, the CGT provisions now
treat the right to sue for damages (and giving up the right to sue) as an asset
which can be disposed of by obtaining an award of damages or by accepting a
settlement, and the settlement amount is exigible under the CGT provisions of
ITAA.
Generally, there will be a better CGT outcome if the amount received can be
attributed at least partly to an “underlying asset” (for example, damaged
property) rather than solely to the asset embodied in the right to sue. If the
amount is an undissected amount and the taxpayer cannot make a reasonable
estimate of the income and capital components, the whole amount will be
taken to relate to the disposal of the tax payer’s right to sue: Tax Ruling 95/35
(TR 95/35).
The Commissioner is of the view that if it is possible to dissect a lump sum
payment using such devices as evidence presented before the court or
formulation of the loss in the pleadings or particulars, that can be done in order
to identify revenue and components: TR 95/35, paras 188-209.
Income tax: damages claims where the issue of income tax may typically arise
Typically, it may be necessary to give consideration to the income tax where:
(a)
the award of damages may have the quality of income in the
hands of the recipient (ie where it is ‘income according to
ordinary concepts’);
(b)
the award is in the nature of insurance or indemnity in respect of
recoupment of a loss (ITAA 1997 s. 20.20(2)).
(c)
the plaintiff has obtained an allowable deduction in respect of
4
the loss for which damages are awarded.
The Court’s approach to the incidence of income tax in assessing damages
•
Background
A convenient starting point is British Transport Commission v Gourley5. That
case involved a personal injuries claim. The House of Lords considered whether
the plaintiff’s damages for lost past and future earnings should be assessed by
reference to the pre-tax or after-tax earnings which the plaintiff would have
derived if he had not sustained the injury.
The House of Lords held (Lord Keith dissenting) that the damages should be
assessed by reference to the plaintiff’s earnings after deduction of income tax.
This was said to give effect to the fundamental principle that damages should
be awarded to an injured party in such a way as to put that party in the same
position he or she would have been in if the injuries had not been suffered.
Initially, in Atlas Tiles Ltd v Briers6, a wrongful dismissal claim, a majority of the
High Court in Australia (Barwick CJ, Jacobs and Murphy JJ, Gibbs and Stephen JJ
dissenting) rejected the Gourley approach, holding that the assessment of
damages should be based on the lost earnings of the plaintiff, without any
deduction for the income tax which would have been payable by the plaintiff in
respect of those earnings had they been made.
Shortly after Atlas Tiles, a differently constituted High Court reversed that
position in Cullen v Trappell.7 The majority (Gibbs J, with whom Mason and
Wilson JJ agreed) rejected the approach in Atlas Tiles and applied Gourley,
holding that the appropriate measure of the plaintiff’s damages should be
based on the plaintiff’s lost after-tax earnings.
Cullen v Trappell continues to govern the position in relation to personal injuries
5
[1956] AC 185
6
(1978) 144 CLR 202
7
(1980) 146 CLR 1
5
claims. However, in non-personal injuries litigation the position can be more
problematical.
•
Wrongful dismissal claims
One area where there has been a divergence of judicial views as to the
treatment of taxation in assessing damages are cases involving claims for
damages for wrongful dismissal.
In 1984, the ITAA 1936 was amended to provide that the assessable income of a
tax payer shall include the amount received by way of an ‘eligible termination
payment’. The expression ‘eligible termination payment’ was defined to include
a payment made by compulsion of law.
In Kilburn v Ezned Precision Products (Aust) Pty Ltd8, O’Bryan J held that, as a
result of those amendments, the Court should no longer take into account
taxation in calculating damages for loss of earnings in a claim for wrongful
dismissal because the damages awarded to the plaintiff were likely to be
assessable as an ‘eligible termination payment’. That approach was followed in
a number of subsequent wrongful dismissal cases: see Wheeler v Philip Morris
Ltd ;9 Grout v Gunnedah Shire Council;10 Reilly v Praxa Ltd.11
In New South Wales Cancer Council v Sarfaty,12 the New South Wales Court of
Appeal took a different approach, assessing the plaintiff’s damages on the basis
of the plaintiff’s after tax salary, but adding an additional amount to
compensate the plaintiff for the income tax payable on the judgment.
8
(1988) 4 VIR 31
9
[1989] FCA 230
10
(1995) 129 ALR 372
11
[2004] ACTSC 41
12
(1992) 28 NSWLR 68
6
This approach was followed in Patterson v Middle Harbour Yacht Club,13 where
Whitlam J assessed the plaintiff’s damages on the basis of his lost after-tax
earnings, and added to that figure an amount to compensate the plaintiff for
the tax payable on the damages award as an ‘eligible termination payment’,
observing:
‘In the present case I propose to apply the method used in Sarfaty. It
would, in my opinion, be unjust not to do so. The damages award will be
taxable as an eligible termination payment. It is agreed that the tax rate
(including Medicare levy) on such a judgment will be 31.4 per cent. If I
"gross up" the relevant part of the damages by that percentage, that
should provide just compensation to Mr Patterson for his loss of earnings
and the value of his lost benefits. (I realize that, as noted in Sarfaty by
Mahoney JA at 96, the method is not perfect.) The alternative approach,
which is to ignore the impact of taxation on the damages awarded,
requires that loss of earnings be calculated by reference to gross wages.
This would result in an unnecessary windfall for Mr Patterson, since the
loss in his gross annual earnings exceeds $60,000 and the vast bulk of this
amount would have been taxed at a marginal rate of 47 per cent.’
An example of this grossing up calculation appears in the reasons of Heerey J in
Martin v Tasmania Development and Resources.14
The concept of ‘eligible termination payment’ was abolished from 1 July 2007.
Section 82.130 ITAA 1997 now deals with ‘employment termination payments’,
which is defined being a payment received ‘in consequence of the termination
of your employment.’ The treatment for the purposes of assessing damages for
wrongful dismissal remains essentially unchanged.
Recently, in Guthrie v News Limited15 a wrongful dismissal case, Kaye J followed
Kilburn v Ezned Precision Products (Aust) Pty Ltd, calculating damages on the
basis of the plaintiff’s gross income, rather than grossing – up damages assessed
13
[1996] FCA 1326
14
[1999] FCA 593 at [95]
15
[2010] VSC 196; see also Quinn v Jack Chia (Australia) Limited [1992] 1 VR 567, 581.
7
on an after take basis. That approach was reiterated, obiter, by Kaye J in
Davinski Nominees Pty Ltd v I & A Bowler Holdings Pty Ltd, 16his Honour noting
that it was not consistent with New South Wales Cancer Council v Sarfaty.
It appears, therefore, that there is an inconsistency in the approach to
assessment of damages in wrongful dismissal cases.
Compensation for wrongful dismissal would normally be exempt from CGT ITAA
97 s.118-37.
•
The Court’s approach where there are difficulties in assessing tax
implications
Where there may be uncertainty associated with how a particular plaintiff will
be assessed for income tax or the basis of that assessment, the Courts have
taken a number of different approaches. ‘Grossing-up’ the damages will not
always produce a just outcome because the plaintiff’s particular circumstances
may impact upon the amount of income tax ultimately payable.
In Daniels & Ors v Anderson 17the New South Wales Court of Appeal considered
whether income tax should be taken into account in assessing damages in the
context of proceedings by AWA against its auditors for failure to detect losses
incurred in foreign currency dealings.
At first instance, Rogers J assessed damages at $13.6m plus interest. His Honour
further directed that that amount should be reduced to take into account the
difference between the higher rate of company tax which was applicable at the
time the losses were incurred and the lower rate of company tax which applied
at the time of judgment.
The plaintiff successfully appealed this part of the judgment.
16
[2011] VSC 220 at [61]
17
(1995) 37 NSWLR 438 CA
8
In their joint judgment, Clark JA and Sheller JA (Powell JA concurring) articulated
the following four propositions at 585:
1. If an award is made for loss of earning capacity and the verdict is not
taxable, it is appropriate to assess the amount of verdict by reference
to nett earnings after tax;
2. In making such an assessment and using tables to determine the
present value of future economic loss regard should be had to the
notional tax on the income assumed to be derived from the amount
awarded for the future economic loss;
3. If a comparison between taxable receipts for which damages are
recoverable and the taxability of the compensatory verdict are so
uncertain and depend upon such imponderables as the degree to
which the plaintiff can, for example, carry forward losses from
previous years, the appropriate course is to ignore taxation
considerations;
4. If on the other hand it is unjust not to take account of identifiable
and quantifiable taxation impacts both on the lost receipts and the
compensatory damages then these may be taken into account in
assessing damages.
Applying those principles, Clark JA and Sheller JA held that the difficulty of
arriving at an amount to allow for the difference in the two corporate tax rates
was such that it should be ignored in assessing AWA’s damages.
The recent Victorian Supreme Court decision of Kaye J in Davinski Nominees Pty
Ltd v I & A Bowler Holdings Pty Ltd 18 is an example of the Court not taking tax
into account because of the difficulty of making an assessment. The case
18
[2011] VSC 220
9
involved assessment of damages claimed by a tenant required to vacate
premises pursuant to an interlocutory injunction. The notice requiring the
tenant to vacate was subsequently held to have been invalid and the tenant
claimed damages pursuant to the undertaking as to damages given by the
landlord in support of the interlocutory injunction.
The question was whether, on the materials before the Court it was possible to
conclude that there was sufficient certainty as to the taxation implications of an
award of compensation to the tenant. Kaye J said at [59]:
“On the other hand, a difficulty may arise where there is a degree of
uncertainty attaching to the nature, or the amount, of the taxation which
might be imposed on the award of damages. In such a case, the law is
cautious about taking into account the tax implications of such an award.
In particular, where that process would involve a number of assumptions
or imponderables, an award, taking the taxation implications into
account, may not constitute fair and just compensation. In that event, an
award of damages, based on the plaintiff’s lost post-tax damages, might
be liable to the imposition of an amount of taxation, in respect of which
the plaintiff is not properly compensated. Further, in such a case, the
assessment of damages would involve an impermissible degree of
speculation, and become unduly entangled with collateral issues involving
the complexities of taxation law. It is those considerations which explain
the caution expressed by Gibbs J in Atlas Tiles v Briers, and which are
reflected in the third proposition stated by Clark JA and Sheller JA in
Daniels & Ors v Anderson. Where there is a lack of reasonable certainty as
to the existence, nature or quantification of the tax liability of the
damages verdict, an award of damages, in such a case, could not be
described as being unjust or unfair, if it were assessed without taking into
account taxation.”
In Sydney Refractive Eye Surgery Centre Pty Ltd v Commissioner of Taxation,19
the issue was whether the applicant was liable to income tax in respect of
damages awarded in defamation proceedings which had been instituted in the
Supreme Court of New South Wales. The plaintiff’s damages were assessed at
19
[2008] FCA 454
10
first instance by reference to the plaintiff’s loss of profits in consequence of the
defamatory publications. The specific question was whether the damages of
$812,726.00 (after allowing for costs) was ‘income according to ordinary
concepts’ for the purposes of s. 6-5 of ITAA 1997. The proceedings arose out of
a private ruling given by the Commissioner to the applicant.
At the commencement of his reasons, Sackville J made the following procedural
observation:
“(The trial judge) specifically addressed the question of whether the sum
would be regarded as ‘income according to ordinary concepts’, within the
meaning of s.6-5 of the ITAA. His Honour decided that it should not be so
regarded and that, in order to avoid over-compensating SRSC (the
applicant), its damages were to be reduced by 36% to take account of the
tax that it would have had to pay on the profits lost in consequence of the
defamatory broadcasts. Apparently, SRSC did not ask Studdert J (the trial
judge) to make an order allowing SRSC to apply for an increase in the
damages award if the Commissioner subsequently regarded the damages
received by SRSC as ordinary income and part of its assessable income for
that reason.
If the Commissioner’s contentions in the present proceedings are correct,
SRSC may find itself in the position of having to pay income tax on a
damages award already reduced to take account of its notional income
tax liability. Perhaps more significantly, this Court would have reached a
conclusion inconsistent with that reached by the Supreme Court in a
judgment that has not been the subject of an appeal. Courts have
adverted to this problem on other occasions and suggested that it should
be open to join the Commissioner as a party in proceedings in which
damages are to be assessed: Gill v Australian Wheat Board [1980] 2
NSWLR 795 at 797 per Rogers J; Provan v HCL Real Estate Ltd (1992) 24
ATR 238 at 247 per Rolfe J. This case may be a further illustration of the
need to consider procedural changes designed to enable a court to
determine the impact of taxation on a damages award once and for all
and to encourage the parties to take steps in an appropriate case to
ensure that this is done”.
These observations underscore the importance of giving close attention to the
potential tax implications of a damages claim well before the trial, and in
complex matters, advising the client to obtain expert accounting advice. It is
important to also give attention to the form of any orders which may be sought
in order to preserve your client’s position in the event that income tax or CGT
11
are subsequently assessed upon an adverse or unpredicted basis.
Assessable recoupments: ITAA 1997 s.20-20
Section 20-20(2) ITAA 1997 provides:
(2) An amount you have received as recoupment of a loss or outgoing is
an assessable recoupment if:
(a) you received the amount by way of insurance or indemnity; and
(b) you can deduct an amount for the loss or outgoing for the current
year, or you have deducted or can deduct an amount for it for an
earlier income year, under any provision of this Act.
A ‘recoupment of a loss or outgoing’ is defined in s.20-25 to include any kind of
recoupment, reimbursement, refund, insurance, indemnity or recovery,
however described.
Thus assessable income includes an assessable recoupment of a loss or
outgoing if the loss or outgoing can be deducted in the current year, or has
been deducted in one or more earlier income years.
A recent example of ‘grossing – up’ damages to take account of assessable
recoupment is the decision Hulme J in Tomasetti v Brailey.20 In that case, the
plaintiffs, Mr and Mrs Tomasetti and Mr Tomasetti’s superannuation fund,
commenced proceedings against their accountants seeking damages in respect
of a number of failed timber plantation investment schemes. It was claimed
that the professional advice the plaintiffs received about entering into the
investments was deficient. The plaintiffs claimed in negligence, breach of
contract, breach of s 42 of the Fair Trading Act 1987 (NSW), breach of a
number of provisions of the Corporations Act 2001 (Cth) and breach of fiduciary
duty. The plaintiffs had suffered losses in the scheme and had claimed taxation
deductions in respect of those losses.
There was agreement that an award of damages may be subject to tax in the
hands of the plaintiffs, but there was disagreement as to the appropriate
method to calculate the damages on an after tax basis. The experts were also
20
[2011] NSWSC 1446.
12
unable to agree as to the tax treatment of an award of damages: whether the
damages would be subject to income tax, and not capital gains tax, in the hands
of the plaintiffs. There was also no agreement as to whether all of the revenue
losses were, in fact, deductions.
The plaintiffs submitted that an award of damages would be assessable as
ordinary income within the meaning of s.6-5 ITAA: It was contended that
“amounts received in the course of or on the conclusion of a business as a
recoupment of lost income or deductible business expenditure partake of the
same character as that which they replace”. It was submitted that the outgoings
incurred by the plaintiffs reduced their taxable income, and an award of
damages in compensation for their outgoings would fill the hole in their taxable
income.
His Honour rejected that characterization of the losses, holding that the
damages came within the concept of an assessable recoupment within
Subdivision 20-A of the ITAA 97. As noted above, “recoupment of a loss or
outgoing” as defined in s 20-25 ITAA, includes “any kind of recoupment,
reimbursement, refund, insurance, indemnity or recovery, however described”.
Assessable income includes an assessable recoupment of “a loss or outgoing” if
the loss or outgoing can be deducted in the current year, or has been deducted
in one or more earlier income years (s 20-35 and s 20-40).
His Honour observed that in reality, the plaintiffs were seeking to recover for
their losses in terms of expenditure and extant liabilities. No attempt had been
made to claim income they had an expectation of receiving.
His Honour further held that any damages should be grossed-up to take into
account that the damages would be assessed as a recoupment.
Allowable deductions
There are a number of recent cases where the Court has reduced the award of
damages to take into account that the plaintiff has obtained the benefit of tax
deductions: see, for example, Australian Breeders Co-Operative Society Ltd v
13
Griffith Morgan Jones;21 Spiteri v Roccisano.22
The issue before the Full Federal Court in Australian Breeders Co-Operative
Society Ltd was whether allowance should be made for future deduction in
relation to subsequent years.
The case involved syndicate members who had invested in a stock breeding
enterprise promoted as having taxation benefits for investors. One novel
argument advanced by the defendants was that:
"If the Syndicate Members do not claim deductions, or the time expires
before they claim those deductions, their failure to make those claims
constitutes an unreasonable failure to mitigate their losses. In these
circumstances, the damages awarded to the Syndicate Members must be
reduced to take into account the amount of the tax benefit that would
[have] been received if tax deductions had been claimed.
Capital Gains Tax implications
•
Statutory framework
Damages recoverable in commercial litigation may be exigible for CGT under Pt
3-1 and 3-3 ITAA 1997, which from 1998 replaced the former CGT provisions
contained in Part IIIA ITAA 1936.
The CGT provisions may be described as “catch-all” provisions, applying to all
gains that arise as a result of a CGT event happening, whether or not the gains
are of a capital nature. Where a capital gain arises from a ‘CGT event’ and an
amount is also assessable under some other non-CGT provision of the ITAA,
double taxation is avoided by reducing or eliminating the amount of the capital
gain.
A taxpayer’s assessable income includes any ‘net capital gain’ for the income
year. A net capital gain is the total of capital gains for an income year reduced
by any recognised capital losses. A capital loss cannot be deducted from a
21
[1997] FCA 1405
22
[2009] VSC 132
14
taxpayer’s assessable income, but it can reduce a capital gain in the current
income year or in a later income year.
The CGT provisions introduced in ITAA 1997 provide that liability to CGT arises
upon the occurrence of a ‘CGT event’. The categories of CGT events are
contained in Div. 104 and are listed in a table in s.104.5. CGT events are
described by number (eg CGT event A1).
A capital gain or loss can arise if a CGT event happens: s102-20. There may be
more than one CGT event to be considered in the context of assessing damages
or compensation. For each CGT event it is necessary to determine, in the
manner prescribed, the time when the event occurs, and to identify whether
any capital gain or loss has arisen from the CGT event. The specific time when a
CGT event happens may be important in working out whether a capital gain or
loss from that CGT event affects the taxpayer’s income in a particular year.
As a general principle, capital gain is calculated as capital proceeds less the CGT
asset’s cost base. Ordinarily, if there is more than one CGT event, the
Commissioner will apply the event that is most specific to the taxpayer’s
situation (s102-25) – that in itself adds a level of uncertainty to the analysis.
Most relevantly, in a litigation context, the CGT events which will need to be
considered are:
•
CGT Event A1 “Disposal of a CGT asset” (s104-10). A CGT event A1 will
occur, inter alia, where a property is forfeited or resumed under a state
law;
•
CGT Event C1 “Loss or destruction of a CGT asset” (s104-20). A taxpayer
makes a capital gain from CGT event C1 if the capital proceeds from the
loss or destruction of the asset are more than its cost base. If the capital
proceeds are less than the reduced cost base of the asset, a capital loss
is made.
•
CGT Event H2 “Receipt for event relating to a CGT Asset” (Section 104155).
15
As will be appreciated from what is said above, another relevant definition is
‘CGT asset’. Most CGT events involve a ‘CGT Asset’. However, some CGT events
are concerned directly with capital receipts and do not involve a CGT asset at
all.
The expression CGT asset is defined in s.108-5 as any kind of property or ‘a legal
or equitable right that is not property’. It expressly includes any interest in
goodwill, a partnership or asset of a partnership, shares, units in a trust, debts
and a right to enforce a contractual obligation. It will include most choses in
action. Thus, for example, in CSR Ltd v Commissioner of Taxation23 Gyles J
accepted that an un-dissected lump sum payment of $100 million received by
the tax payer in settlement of litigation over the extent of indemnity under an
insurance policy, was exigible as a capital gain under the former Part IIIA.
•
Some exceptions to CGT
Damages at common law for personal injury are not caught by either the
income tax or capital gains tax provisions: s.118-37(1). That section provides
that the following are not subject to CGT:
a) Compensation for wrong or injury suffered in the tax payer’s
occupation;
b) Compensation for any wrong, injury or illness suffered by the tax
payer or the tax payer’s relatives personally.
An award of damages that is entirely of an income or revenue character will be
exigible as ordinary income, and is protected against CGT by s118-20. To the
extent that such a gain results in ordinary income tax, the gain from a CGT event
is reduced. However, if the award is of a mixed nature, comprised of items of
capital and items of an income nature without differentiation, then the entire
award will be treated as capital and the CGT provisions generally govern the
position.
CGT does not apply to an asset acquired before 20 September 1985. Further, an
23
[2000] FCA 403
16
asset is not a CGT asset if the asset was last acquired before 26 June 1992 and
was not an asset for the purposes of former Part IIIA of ITAA 1936.
Not all awards of damages or compensation are exigible. In many cases there is
no net capital gain or capital loss effect at all. A helpful discussion of the Court’s
approach to determining whether an adjustment should be made in assessing
compensation or damages is contained in the judgments of the New South
Wales Court of Appeal in Inglebrae Coal Pty Ltd v New South Wales Coal
Compensation Board.24
In Inglebrae Coal the question involved the incidence of CGT upon
compensation received for compulsory acquisition of coal. The appellant was
assessed as liable for $2.105m CGT on the statutory compensation, and sought
additional compensation in respect of that CGT liability.
Santow JA observed25that a number of cases had held that capital gains tax
should not be the subject of additional compensation, referring to Fedorovitch v
St Aubins Pty Ltd (No 2)26 (compulsory sale of shares in an oppression suit),
Osric Investments Pty Ltd v Woburn Downs Pastoral Pty Ltd 27(for breach of
contract or contravention of the Trade Practices Act); Namol v A W
Baulderstone (No 2)28 (damages for breach of copyright where in any event it
was not clear whether or not capital gains tax would be payable) and Joondalup
Gate Pty Ltd v the Minister for Lands as delegate for the Minister for Works29
(where in the context of compulsory acquisition of land, Parker J of the West
Australian Supreme Court sitting with Assessors as the Western Australian
Compensation Court, disallowed compensation for capital gains tax upon
24
(2003) 58 NSWLR 362
25
(2003) 58 NSWLR 362 at 384
26
(1999) 17 ACLC 1558
27
[2001] FCA 1402; (2002) 20 ACLC 1
28
(1993) 47 FCR 388
29
(1996) 33 ATR 327
17
compensation where the resumption was pursuant to the Land Acquisition and
Public Works Act 1902).
His Honour considered that where an investor acquired property which was to
be disposed of at some future time with the prospect of CGT, the resumption
simply brought forward the time at which the tax was imposed, rather than
exposing the investor to an unforeseen tax liability. In that case, there was no
need to provide further compensation of CGT. However, in Inglebrae Coal, the
position was different. The acquisition deprived the plaintiff of the ability to
receive a revenue flow of royalties into the future. Consequently, the appellant
was exposed to a different liability to that which would be experienced as a
recipient of the revenue from royalties. It was not a situation where CGT
liability simply came earlier than otherwise expected. Consequently, there was
a basis for adjustment to the amount of compensation.
•
TR 95/35
As earlier noted, when considering whether an award of damages is potentially
exigible for CGT, reference should still be made to TR 95/35, which although it
pre-dates ITAA 1997, is still relied upon by the Commissioner.
TR 95/35 is entitled ‘Income tax: capital gains: treatment of compensation
receipts’, and is expressed to apply to a person who receives an amount as
compensation. It considers the CGT consequences for the recipient of the
amount, and whether the amount should be included in the assessable income
of the recipient.
Compensation is described as including any amount (whether money or other
property) received by a taxpayer in respect of a right to seek compensation or a
cause of action, or any proceeding instituted by the taxpayer in respect of that
right or cause of action.
Without here seeking to exhaustively summarise TR 95/35, a number of
fundamental propositions can be drawn from it:
18
1.
The CGT consequences for an award of damages depend on whether
there is an underlying asset to which the damages have a direct and
substantial link. Such a link may be established if there is a CGT asset
which has been disposed of, permanently damaged or reduced in value
by the circumstances which generated the right to compensation.
2.
If a CGT event has happened to the underlying asset, the compensation
is treated as capital proceeds. If the asset was a pre-CGT asset, or is
otherwise exempt, the compensation will have no CGT consequences. If
the asset is post-CGT, a capital gain or loss may arise from the CGT
event.
3.
If a CGT event does not happen to the asset, but it has been
permanently damaged or reduced in value, the compensation is treated
as a recoupment of part of the total acquisition cost of the asset. Its cost
base and reduced cost base are decreased by the amount of the
recoupment.
4.
If there is no underlying asset, the receipt compensation is generally
treated as capital proceeds from a CGT event which happens in relation
to an asset, being the right to seek compensation itself.
5.
If the compensation amount relates to a number of heads of claim and
cannot be allocated on any reasonable basis between those heads of
claim, the whole amount is taken to relate to the disposal of the
taxpayer’s right to seek compensation. If one of the undissected
components relates to an exempted component, such as a personal
injury to the taxpayer, the exemption which may otherwise be available
does not apply.
6.
Where damages are awarded for non-performance of obligations under
a contract for the sale of property, a capital gain normally arises, either
on the disposal of the right to sue (CGT event A1 or because a CGT event
H2 happens).
19
TR 95/35 includes a number of worked examples of the calculation of CGT gains
and losses in relation to damages and compensation claims, and should be
consulted in relation to any question relating to the CGT implications of an
award of damages or receipt of compensation.
•
Judicial approaches to adjusting for CGT in assessing damages
Some of the authorities referred to below concerned the former provisions of
Part IIIA ITAA 1936, but remain relevant to a discussion about the approach to
be applied in taking CGT into account.
The incidence of CGT in compensation and damages awards has been
recognised in a number of cases. Each case, of course, has to be considered on
its own facts. However, there has been a lack of consistent approach to the
incidence of CGT in adjusting damages awards. In a number of cases, to
preserve the compensatory effect of an award of damages, courts have
‘grossed-up’ the award so that, when taxed at the rate applicable to the
particular plaintiff, full compensation is obtained. In undertaking the ‘grossingup’, however, it is insufficient to simply add back the tax, because the aggregate
of the award and ‘grossed-up’ amount collectively attract CGT. A further
adjustment has to be made to take account of that effect. The exercise is made
all the more difficult where there are apportionable claims or findings of
contributory negligence.
In other cases, the Courts have made orders which are expressed to be
conditional upon whether, and to what extent, the taxpayer is later assessed for
CGT. This raises issues about finality of judgments.
The following cases illustrate several different approaches:
•
In Provan v HCL Real Estate Limited30 a vendor sued a real estate agent,
alleging that the agent had falsely informed the plaintiff that there was
only one interested buyer in the plaintiff’s property, encouraging the
30
(1992) 92 ATC 4644
20
plaintiff to sell at an under value to that buyer. The plaintiff alleged that
the agent had acted in breach of contract, in breach of fiduciary duty
and in breach of a duty of care owed to the plaintiff. Rolfe J held that if
the property had been submitted to auction a substantially greater price
would have been achieved. His Honour assessed damages at
$955,450.00, being the difference between what was likely to have been
achieved at auction and the actual price obtained by the plaintiff. In
assessing damages, His Honour held that the liability to CGT was
reasonably foreseeable and was causally related to the breach of duty,
and that an indemnity against the incidence of CGT should be provided
for in the award of damages. His Honour made a declaration that if the
plaintiff was held liable to pay capital gains tax on the judgment, the
defendant should meet that further liability.
•
In Tuite v Exelby 31 an action was brought on a restrictive covenant
preventing the vendor of a stockfeed business being involved in the
same kind of business for a period of two years. Shepherdson J found
that as a consequence of the breach by the defendant of the restraint,
the value of the plaintiff’s shares in the stockfeed company purchased
from the defendant had been diminished. His Honour increased the
award of damages by $517,191.00 by way of a CGT indemnity. His
Honour further ordered that the plaintiff give an undertaking that in the
event CGT was not assessed, or was assessed in a lesser amount, the
plaintiff would refund the excess to the defendants. The decision was
reversed on appeal on other grounds.
•
In Rabelais Pty Ltd v Cameron32 Hodgson J assessed damages but
reserved leave to the plaintiff to apply for additional damages in the
event that the award was assessed for CGT.
31
(1992) 93 ATC 4293
32
(1995) 95 ATC 4552
21
•
In Duke Group Ltd v Pilmer,33the Full Court of the Supreme Court of
South Australia concluded that it was open to the trial judge to make a
conditional order for indemnity of the plaintiff in the event that the
award was assessed for CGT.
•
At first instance in Sydney Refractive Eye Surgery Centre Pty Ltd v
Beaumont34 (referred to above in relation to income tax) Studdert J
recognised that SRSC might be liable to capital gains tax on the award of
damages, but thought that justice could be done by reserving leave to
SRSC ‘to apply for additional damages referable to capital gains tax
considerations should SRSC be found liable to pay such tax’.
Conclusions
In Interchase Corporation Limited v ACN 010 087 573 P/L 35the plaintiff sought
to have the Court vary an order giving judgment against one of the defendants
for approximately $28m. The variation plaintiff sought to add the following
declaratory relief:
"I declare that if Commissioner of Taxation seeks remittance from the
plaintiff of, or otherwise holds the plaintiff liable to pay, any GST as
defined in A New Tax System (Goods and Services) Tax 1999 (Cth) in
relation to any and all sums and benefits (whether monetary or
otherwise) (`the Benefits') whatsoever awarded to the plaintiff under this
judgment, then
(i) the plaintiff is entitled to be indemnified for any Goods and Services
Tax for which it is liable to pay to the Commissioner of Taxation; and
(ii) the plaintiff is entitled to be indemnified for all costs and expenses on
a solicitor and own client basis in the proper defence of any claim for the
payment of any Goods and Services tax in respect of the Benefits."
White J declined the application, observing:
33
[1999] 73 SASR 64
34
[2004] NSWSC 164
35
[2000] QSC 13
22
[50] The damages which are now sought to be included in the judgment
were not pleaded nor made an issue in the trial. It is not the case that this
new tax has recently come into the Australian community. Its imposition
was made clear, at least from the commencement of the trial, and there
was ample opportunity to formulate such a head of damage and to deal
with it in a timely and appropriate manner. …
[51] There are other issues which would need to be examined, for
example, the net effect of other tax payments and whether or not the
plaintiff had a threshold turnover in order to raise the potential of a GST
liability. There must be some foundation in law for requiring the third
defendant to indemnify the plaintiff for any liability for GST. It must arise
as a consequence of the negligence of the third defendant and the plaintiff
has failed to advance any argument to support this. There is no apparent
recognition of the limiting effect of remoteness of damage. On any view,
the potential liability to pay GST was not reasonably foreseeable at the
time when the breach occurred. These uncertainties are sufficient to refuse
the relief sought …”
This was not a CGT case, but her Honour’s observations underscore the
importance of giving attention to any potential income tax and CGT implications
of an award of damages, whether the client is the plaintiff or the defendant.
This paper is not intended to contain a comprehensive analysis of all possible
income tax and CGT considerations applicable in any particular case. Its
purpose is rather to identify a number of areas where these issues are likely to
arise, particularly in commercial litigation, and to focus our minds upon those
issue well ahead of the trial.